Housing Supply Isn’t So Short. What That Means for the Housing Market–and the Economy (March 5, 2023)

Official data may not accurately reflect the true state of the U.S. housing market.

By Lisa Beilfuss
March 5, 2023

Economic turns often hinge on housing. Investors should be wary of assumptions that the housing market has bottomed.

Housing optimism is spurring renewed hope that the U.S. economy will dash a recession, even after 2022 brought the most aggressive rate hikes in history and even though the Federal Reserve’s tightening campaign appears far from over. The sector makes up nearly a fifth of gross domestic product. More people own homes than have stock-market exposure, meaning households’ willingness to spend is deeply connected to property values. Consider as well that Americans are borrowing against home equity at the fastest pace in more than a decade.

Recent indicators support growing optimism that the worst is over for residential real estate. Sales of new domestic single-family homes rose 7.2% in January, the fourth straight increase to the highest level in almost a year. The NAHB housing market index, based on a survey of builder sentiment, jumped in February to the best level since September 2022. Even a drop in existing-home sales to the lowest level in 12 years was well received as some analysts said a slowdown in the pace of decline means that a bottom is near.

But there are several reasons why investors should remain skeptical that housing is turning a corner. That isn’t to predict housing armageddon. There are some factors, such as the level of M2 money supply still 38% above pre-pandemic levels, that support a higher floor than might otherwise be the case. The point is that the worst probably isn’t close to over for real estate, which upends some broader, positive assumptions about the strength of the U.S. economy and financial markets.

The first two reasons to question housing optimism are straightforward. First, monetary policy works with a lag. Michael Kantrowitz, chief investment strategist at Piper Sandler, says it is naive to expect any kind of economic or market bottom now given that the first hike in this cycle was not quite a year ago.

“This is the nastiest tightening cycle we’ve ever seen, and it takes 15 to 18 months to show up,” says Kantrowitz. Already-implemented Fed policy may only be starting to spur layoffs and broader contraction, and that is to say nothing of the risk the Fed tightens more and holds rates higher for longer than anticipated. Housing will worsen as long as either mortgage rates rise or employment deteriorates, Kantrowitz says.

Second, the falling mortgage rates that boosted recent housing activity have reversed and aren’t yet hitting the data.

The third reason to doubt an imminent housing bottom runs contrary to the conventional wisdom underlying most housing-market analysis: Housing supply may not be as short of demand as presumed.

Investors tend to focus on existing homes because they represent a bigger share of the overall market. Supply of previously owned homes is all but frozen as 99% of current mortgages have interest rates below current market rates, according to Goldman Sachs. Months supply of existing homes, or the number of months it would take for current inventory to sell at the current sales pace, is at an historically low 2.9. Months supply for new homes stands at 7.9, resulting in an unusually large gap between the supply of existing and new homes.

Oversupply in one area doesn’t neatly solve undersupply in another. And new homes aren’t perfect substitutes for existing homes because new construction is often more expensive and in less-appealing areas. But housing under construction remains near record levels, and some analysts say new homes are close enough substitutes for existing homes–especially given the dearth of previously owned homes for sale. What is more, new-home supply may be much higher than data show, threatening a real-estate price shock as builder price cuts weigh on existing-home prices.

Melody Wright has been in the housing business since 2006 and now runs a mortgage strategy and fintech company. Suspicious of dovetailing narratives that housing supply remains scant and real estate is bottoming, she hit the road. “I needed to know for myself,” Wright told Praxis on day nine of her roadtrip to survey new-home communities and construction sites in and around Nashville, Tenn., Austin, Texas, Tampa and Jacksonville, Fla., and Charlotte, N.C.

She described development upon development with little to no occupancy or potential-buyer traffic. In one stretch near Round Rock, Texas, about 20 miles north of Austin, she counted seven new developments within a span of a mile where the price per square foot was around $279, 26% above the national average.

“They park construction trucks and cars from the workers and pull the new garbage cans to the road to make it look like the homes are occupied,” Wright said, referring to developers’ attempts to demonstrate signs of life. She told of coming-soon signs across exurbs and megasites promising in 2022 gas stations and grocery stores that don’t exist and of sheriffs policing empty sites.

“The emptiness, the desolation, it is wild,” she says of sites across the states she surveyed. “Bubble is too light a word to describe this oncoming storm.”

Homebuilders are already reporting faltering deals. KB Home (KBH), for example, said customers backed out of 68% of signed contracts in the fourth quarter. A sales representative for one of the country’s biggest builders warns the situation is more dire. In recent months, sales reps have mostly written unqualified contracts they know won’t close for fear of missing quotas and being fired, the person says.

“Builders are inflating the numbers,” says the person, meaning inventory is likely higher than reflected because many deals won’t close. “Most new sales are worthless.”

Housing analyst Ivy Zelman, co-founder of Zelman & Associates, has warned that new-home construction is ahead of demand and that estimates of a housing-supply deficit are overblown. The problem, she said in a 2021 interview with The Real Deal, is that demand isn’t insatiable but a mirage. The market moved too fast to accurately track it, in part because historically low mortgage rates and the Fed’s massive bond-buying program supercharged record investor purchases of single-family homes.

Investors bought about a quarter of properties sold during the pandemic boom, up from an average of about 15% in the prior decade. Small investors, as opposed to institutions, comprise the vast majority of the investor category. Many bought properties without physically seeing them, aided by online real-estate investing platforms and debt service coverage ratio, or DSCR, loans.

The DSCR market is small. But banks are securitizing the loans, and the niche speaks to forces that Fed tightening has yet to unwind. Such loans don’t require income verification and are instead based on an estimate of a property’s cash flow. Mortgage broker Gaetano Ciambriello says DSCR loans boomed in popularity during recent years. He adds that customers who have used DSCR loans typically can’t qualify for conventional loans and often take on multiple so-called landlord loans.

Should a property lose value and the DSCR ratio fall below 1, meaning cash flow fails to meet debt-service obligations, a borrower faces default unless it raises the tenant’s rent, refinances, or does both. The former can be tough in a broad downturn, while the latter option requires falling rates and usually involves a prepayment penalty.

The housing market is made up of many moving pieces. An examination of them makes it hard to view the notion that real estate is sustainably recovering as something other than wishful thinking dotted by blind spots. The question isn’t if housing–and thus the economy–will fall from here, but how far and for how long.

Quantitative Easing Debate Misses the Point (March 21, 2023)

Recent central bank interventions suggest the elusive Fed pivot is here–with QE not far behind.

By Lisa Beilfuss
March 21, 2023

The debate about whether the Federal Reserve’s latest emergency lending is a stealth form of quantitative easing misses the bigger picture. Financial and economic conditions are deteriorating as lagged monetary policy bites, and overt QE is probably coming sooner than some investors appreciate.

In the week ending March 15, the central bank’s balance sheet expanded by about $300 billion, to $8.64 trillion, as banks tapped the Fed’s discount window and new Bank Term Funding Program for emergency liquidity. The new loans in aggregate are equivalent to the amount of quantitative tightening conducted over the past four months, where the Fed has been letting bonds roll off of its balance sheet to reverse some of its $5 trillion in pandemic purchases.

The latest infusions aren’t exactly QE. They are via bank loans as opposed to outright Fed asset purchases, and about half of those loans appear to be on account of a few troubled banks tapping the Fed’s discount window. Many economists and strategists say banks will hang on to the new cash that is intended to plug holes in banks’ balance sheets, versus lend it, meaning the money lent to institutions won’t stimulate the economy. Moreover, they say the Fed’s balance-sheet boom reflects the kind of pain that portends tighter credit conditions and broader economic contraction.

But some say it isn’t so black and white. Joe LaVorgna, chief U.S. economist at SMBC Nikko Securities, says the recent balance-sheet expansion is “a backdoor way to do QE,” arguing that while the Fed isn’t directly buying securities off of banks’ balance sheets, it is creating bank reserves. A related argument: It can’t be assumed that none of the new money flows out of bank reserves and into the real economy. The idea is that while the latest injections aren’t akin to the QE that fuels risk assets, second-order effects might resemble something more stimulative.

More important than the definition and technicalities of recent interventions is the signal they send to markets. The Fed is boosting bank reserves at a time when monetary policy has been focused on draining reserves. That is not to mention the emergency move to enhance swap lines, allowing foreign central banks to access dollars directly from the Fed daily instead of weekly. The financial strain central bankers are trying to ease now will only worsen as a year of aggressive interest-rate increases start to kick in.

While some strategists suggest the recent efforts to stabilize the banking system give the Fed room to continue tightening through higher interest rates and ongoing QT, any such effort to two-track macro prudential and monetary policy would probably be short-lived and counterproductive.

The Fed has run into the liquidity floor, and hard, says Lyn Alden, founder of Lyn Alden Investment Strategy. “QT is probably over,” she says, “since any further attempts to withdraw liquidity will need offsetting loans to avoid bank runs.”

That isn’t to dismiss inflation concerns. Consider that the Praxis index of essentials within the consumer price index rose 7.8% in February from a year ago, well above the Labor Department’s 6% headline figure. Even excluding the cost of shelter, which high-frequency private data suggest is falling faster than government reports reflect, Praxis finds the prices of basic foods, gas and utilities still rose nearly 8% year-over-year in the latest month.

But the reality is the financial system probably can’t tolerate more tightening–or even the already-implemented tightening that has yet to make its way through the financial system and economy. As Matthew Luzzetti, chief U.S. economist at Deutsche Bank, puts it, “everything, everywhere looks sufficiently restrictive, all at once.” He recently cut his forecast for the Fed’s peak rate to 5.125% from 5.625% and expressed “substantial uncertainty” about the Fed outlook.

Only weeks ago, some economists and investors feared a policy rate of around 6% would be needed to bring inflation back to the Fed’s 2% target. For context, at this time last year Fed officials predicted a terminal rate of 2.8%. Now, calls for substantially more rate increases are fading fast and markets have started pricing in rate cuts as early as June. Apollo chief economist Torsten Sløk quantified the impact of recent bank failures on financial conditions and lending standards, estimating the equivalent of an additional 1.5 percentage point increase in the Fed’s policy rate. That in effect suggests the policy rate has already breached 6%.

Traders have placed 15% odds on a pause when the Fed meeting concludes Wednesday, with the balance favoring another quarter-point increase. The latter result may give way to future rate increases should inflation remain stubborn or reaccelerate. The former outcome would probably speed up rate cuts and the return of QE. LaVorgna of SMBC Nikko predicts classic QE–the kind that fuels risk assets–will return in July, at which point he also expects rate cuts to begin.

Compared with some past tightening campaigns, the fast pace of rate increases gives the Fed more to cut this time before reaching the zero bound and resorting to quantitative easing. But the bank-related events and interventions of the past week suggest the elusive Fed pivot is here–whether or not the Fed follows through with a hike this week.

Data Delusion Sets A Bear Trap (January 19, 2023)

Growing expectations for a soft landing are based in part on lagging labor data. Leading indicators flash warning signs.

By Lisa Beilfuss

One of the most widely-held assumptions about the U.S. economy is increasingly dubious. The labor market is not as tight as presumed, meaning investors should dismiss the renewed soft-landing narrative and prepare for a recession in the coming months. Readers familiar with this writer’s work may recall an April 2022 piece in Barron’s arguing that the Federal Reserve couldn’t cool inflation to its 2% target without triggering a recession. The consensus since then swung to a hard landing, but many economists and investors have recently flipped as a series of robust labor-market data and decelerating inflation figures renew hopes that supply and demand are gliding into balance. A slowdown in the fourth-quarter employment cost index reported Tuesday underpin that sentiment.

The fresh optimism is so strong that even if the rare soft landing happens, it is already fully priced into the stock market, says Jurrien Timmer, director of global macro at Fidelity. That alone is reason to maintain some skepticism. More importantly, the jubilance is folly because the conventional wisdom around the labor market is based on the wrong data. (A subsequent Praxis piece will focus on the inflation picture).

The closely-watched monthly employment situation report from the Bureau of Labor Statistics is a lagging indicator, meaning nonfarm payrolls say more about what has already happened in the economy than what will happen. That is apart from a December Philadelphia Fed report suggesting the U.S. economy added a net 10,500 jobs in the second quarter of 2022–well below the reported 1 million jobs and casting doubt over how strong hiring has actually been.

Worse is the monthly job openings and labor turnover, or JOLTS, report, which has continued to show historically high levels of employee quits and employer job openings. Aside from being particularly stale–February data are released in April–there is particular danger in relying on JOLTS data because the response rate has fallen to an anemic 30%. That is about half the survey’s pre-pandemic response rate.

Responding business answers are imputed to non-responders, notes Warren Pies, founder of 3Fourteen Research, meaning that existing JOLTS data are used to fill in missing responses. The upshot, Pies says, is that healthy businesses are double-to-triple counted, effectively inflating job-opening stats. By that logic, the reported 10.5 million job openings in November may be more like 3.5 million to 5.3 million job openings, where they trended between mid-2011 and early 2015. For context, job openings as reported in the JOLTS report fell to 4.7 million in April 2020, during pandemic lockdowns, from about 7 million at the start of 2020.

Optimists point to a third indicator: initial jobless claims for unemployment insurance, which recently fell to a nine-month low despite job cuts across big tech and beyond. But investors should be wary. First, a discrepancy between layoffs and unemployment claims isn’t new. Economists at Moody’s said in a 2018 report that fewer claims were being initiated for every laid-off worker, in part because many states had implemented program changes making it harder or less attractive to apply for unemployment insurance.

Second, severance may be delaying an uptick in initial jobless claims. Consider the move by Amazon.com (AMZN) to extend full pay and benefits for 60 days to U.S. workers it laid off, followed by varying severance packages. That matters because under some state regulations, and depending how the pay is structured, separation payments can delay or reduce unemployment benefits. Severance has meanwhile become more common. A 2021 report by human-resources consultant Randstadt Risesmart found that 64% of companies are offering severance to all separated employees, up from 44% in 2019.

Not all labor-market indicators are lagging or otherwise flawed for the purpose of predicting economic turns. To the contrary, there are some forward-looking–yet overlooked–data series that are sending a clear message. Employers often cut workers’ hours before eliminating jobs, and average weekly hours fell in December to the lowest level since the pandemic lockdowns. That is as overtime hours have fallen sharply since early 2022. The number of people working part time because they can’t find full-time work is trending higher, while the number of temporary jobs have fallen sharply since peaking in July.

Yet while leading job-market indicators signal weakening conditions, many economists and strategists will continue to emphasize the splashier but lagging nonfarm payrolls, JOLTS and jobless claims indicators. That is in part because central bankers themselves focus on those indicators–meaning an economic downturn may be deeper than even some in the hard-landing camp expect as the Fed weighs stale but sunny labor data alongside slowing, but still high, inflation numbers.

It is one thing to predict an economic downturn and another to try to pin down timing. To do so, Alfonso Peccatiello, founder of the Macro Compass Newsletter, lays out four leading indicators that go beyond the job market. He says the global credit impulse, which tracks the flow of new credit issued by the private sector as a percentage of GDP, together with the Conference Board’s leading indicator index, the National Association of Homebuilders index, and the Philadelphia Fed’s new orders index, suggest a U.S. recession starts in the next four to five months. For now, investors can enjoy a rally as many continue to call the Fed’s bluff on its higher-for-longer interest-rate pledge and believe a goldilocks scenario is unfolding. But it is a bear trap, says George Goncalves, head of U.S. macro strategy at MUFG’s institutional client group.

Risk-market pricing can skew the recession-versus-soft-landing narrative in the short run, he says, adding that markets can fool all of us some of the time. But in the end, “markets can’t trick the economy out of a recession.” Investors should thus remain focused on the data–and the gap between the data that leads and the data that lags yet drives policy. Lagging labor figures will follow what the leading indicators are flashing, and eventually the Fed will respond to a deteriorating job market that will be worse than policymakers, economists and headlines suggest because they are looking backward.